Hedge funds—especially those already focused on high-yield fixed income and distressed credit—are waking to the opportunity represented by the $1 trillion consumer credit market, says Ron Suber, and to the possibility of using peer-to-peer (P2P) lending to tap it.
Suber, who spent 25 years in the brokerage industry—first with Bear Stearns, later with Merlin Securities—recently teamed with his former Merlin colleagues Stephan and Aaron Vermut, and Sequoia Capital to take over and re-fund Prosper Marketplace, an online peer-to-peer lending company.
"Think of us as an exchange," Suber, Prosper's head of global institutional sales, told FINalternatives during a recent interview. "We're connecting lenders and borrowers."
The San Francisco-based firm vets borrowers—people looking for loans of up to $35,000—"verifying and validating" their credit histories and all other pertinent financial information before assigning their loan request an interest rate and listing it on the site.
Prosper's vetting process is stringent; Suber says they turn down the vast majority of would-be borrowers:
"We are looking for borrowers with a minimum 660 FICO score," he said. "We're looking for somebody with the probability and the willingness and the likelihood to pay back the money. We're not looking for someone being chased by a collection firm already, that's not our target client."
Borrowers have "credit card debt, or consumer finance debt, or they may want to buy a nicer wedding dress, or need cash to pay their taxes or...to do home improvements....They're not being served by their banks or credit unions, they're being turned down or they're paying too high of a rate with a credit card company or bank."
Lenders, on the other hand "have cash and it's not getting interest from the banks, or not very much interest and they don't want to buy more stocks or more options or more futures or more real estate, they actually want to get a diversified portfolio of consumer credit where they can get...9% interest accrued daily and, more importantly, paid monthly." Lenders may take on all or part of a loan, offering as little as $25.
The loans themselves are unsecured, which addresses one of reasons some borrowers are unable to get credit from banks.
"I don't think banks want to do a lot of consumer lending and certainly not small-dollar amounts because they don't really make a lot of money, and they can't do it quickly and they want collateral," says Suber.
Once sufficient lenders have been found, Prosper originates a fixed-rate, three- or five-year loan, which it also services. The firm makes its money by charging borrowers a one-time origination fee and lenders a monthly service fee.
Accounting for roughly $500 million of the consumer credit market, Prosper is one of two peer-to-peer lenders currently dominating the space. The other is LendingClub, with roughly $1.5 billion, but as Suber points out, $2 billion is little more than a drop in the bucket of a $1 trillion market:
"This new asset class has started, we're probably in the top of the second inning...and there's going to be tremendous growth—in April you'll see very strong numbers from the two firms."
Future growth, he says, will be driven by institutional investors, particularly those he terms "tax exempt" lenders: IRAs [individual retirement accounts], pension funds, endowments, offshore entities.
"If you're tax-exempt or tax-deferred," he says, "you can get all this interest tax deferred and if you're a pension fund and you don't pay taxes, then you could invest in this, get all the interest and not have to pay tax..."
But the space is also attracting institutions that "get the securitization angle," says Suber. These lenders are buying whole loans so they can securitize them and re-sell them to even bigger institutions "similar to the mortgage market and the asset-backed market and the CLO market...[T]his is literally the second inning, no one's securitized yet, but you can see the demand from institutions to do so in the future. And that's why it's growing so fast."
Suber, who had been doing peer-to-peer lending "as a hobby" for a couple of years, brought Prosper to the attention of Stephan Vermut who was working (along with Aaron) for Wells Fargo which had bought Merlin in 2012.
"Prosper needed institutional management that knew the hedge fund and family office community," said Suber. "Merlin was a financial and technology firm and Prosper is the same thing...that's also our experience as a team, Aaron, Steve and I."
Suber and the Vermuts joined Prosper in January 2013, as Sequoia led a $20 million round of financing which included all existing investors.
The new team has implemented a number of changes at Prosper, including creating an operations group to reconcile activity daily rather than monthly, extending call center hours, becoming more aggressive about collections and opening a New York City office for institutional sales.
Suber says since their arrival, business has increased sharply, a fact he attributes directly to the new team's knowledge of—and connections to—the institutional investment world.
Peer-to-peer lending is such a new phenomenon that the rules regulating it are still taking form.
Prosper, founded in 2006, quickly ran afoul of the Securities and Exchange Commission which ruled that a company selling and undertaking to service loan notes through an internet platform was issuing 'securities' and needed to register with the SEC.
Prosper was shut down in 2008, filed a registration statement with the SEC and undertook regular reporting duties before reopening in 2009.
The effect of institutional investors on peer-to-peer lending remains a subject for speculation, as does the possibility of expanding the peer-to-peer lending mandate to new asset classes, like mortgages and accounts receivable.
As Ron Suber says, it's still early innings.